Wanted to hear everyone’s opinion/thoughts on the best way to think about YOC for value-add deals? Do you guys look at trended YOC for an exit or just a stabilized YOC? How many bps of spread do you look for over the exit cap?
Just curious
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Ah, diving into the nitty-gritty of Yield on Cost (YOC) for value-add deals, are we? Let's peel this banana and see what insights we can gather from the highest ranked content on WSO.
When it comes to YOC, there's a bit of a balancing act between current (untrended) yield vs. stabilized (trended) yield. The approach can vary depending on the specific strategy and risk appetite of the investor or firm. However, based on the wisdom shared in the WSO forums, here are a few key points to consider:
Trended vs. Stabilized YOC: For value-add deals, looking at both trended and stabilized YOC is crucial. Trended YOC takes into account the expected growth in income over the holding period, which can provide a more realistic picture of the deal's potential, especially in dynamic markets. Stabilized YOC, on the other hand, gives you a snapshot of the yield assuming the property has reached its optimal operating performance. It's like comparing the potential of a young, up-and-coming boxer (trended) to a seasoned pro at their peak (stabilized).
Spread Over Exit Cap Rate: The spread between your YOC and the exit cap rate is like the secret sauce in your investment burrito. It's what can make or break the deal's attractiveness. A common benchmark mentioned in the forums is aiming for a spread that's sufficient to compensate for the risk and effort involved in the value-add strategy. While the exact basis points (bps) can vary, a spread of 125 to 175 bps over the exit cap rate is often cited as a ballpark figure to target. This spread acts as a cushion, much like the extra air in a bag of chips, protecting you from market fluctuations and ensuring the deal remains tasty even if conditions change.
Market and Location Considerations: The desired YOC and spread can also depend heavily on the market and location of the property. High-growth areas might allow for a more aggressive approach to trended YOC, while more stable, mature markets might call for a focus on stabilized YOC with a conservative spread over the exit cap.
In essence, the best approach to YOC for value-add deals involves a blend of art and science. It requires analyzing the numbers (the science) while also taking into account the market dynamics and your own investment criteria (the art). Like a master chef, knowing when to stick to the recipe and when to improvise based on the ingredients at hand is key.
Remember, every deal is unique, and the optimal strategy can vary. It's always beneficial to peel through layers of data, consult with peers, and maybe even throw in a bit of your own secret ingredient to find the perfect YOC strategy for your value-add deals.
Sources: Yield on Development Costs, How many deals do you underwrite / do a year?, Real Estate Trends (All Asset Types), Spreads on New Multifamily Development, 1st Year Macro HF Analyst: My Macro Framework
Sounds like a skill issue - pm if you want to chat further
I work in development, and it’s all about untrended YOC. Really strips down the deal to rely on as few assumptions as possible.
Most of our markets are probably 5.50 caps now, although with limited sales comps. We’re targeting at least a 6.50 YOC on our deals, but that’s probably the bare minimum for LPs these days even in strong fundamental markets. We’ve gotten feedback of needing to hit 6.75 - 7.00, but I haven’t underwritten a deal that honestly hits that threshold without an affordable component.
For a value add deal, there’s less risk than ground up dev, so target spread “should” be lower - but there’s a reason money is drying up for development. You can buy plenty of deals going to market today for cheaper than what you can build them for. The fact that development spreads are compressing dangerously similar to what I imagine typical acquisition spreads to be makes things pretty tough right now.
How are you justifying a 5.5% exit cap today? Sure the ‘market’ might be trading like that but with financing costs I have found it so hard to justify. I’m not saying it’s right or wrong; I’ve just been struggling with it myself and have yet to find a good reasoning. (Assuming this is multifamily by the way. )
I built a model to try to figure out this question a couple of months ago. Basically, the assumption that most investors are making today is that in the next few years, rates will "normalize". The way that I set up the analysis was by taking snippets in time that were deemed "stable" (in theory that means when you assume that the exit cap rate is the same as the purchase cap rate) and tried to back into an IRR for a stabilized multifamily asset. I then tried to figure out what the exit cap rate had to be for an asset using today's assumptions for the IRRs to be identical. I don't remember the exact results of my runs but what I found was that for every 1% increase in interest rates in a "stable" environment (no expectation of future increase or decrease in financing costs), the amount the cap rate must increase to produce the same IRR is about 60bps. In today's market for the cap rates to make sense, investors must be assuming that within the next 5 years there will be about 50bps of compression.
In terms of OPs question on YoC, the way to think about it is you're comparing what you're effectively "buying" the asset for if it were delivered stabilized today. When comparing build vs buy, you shouldn't trend rents since you'd benefit from trending regardless of whether you build it or whether you buy it. One of the reasons why a healthy YoC premium must exist is that you're giving up cash flows during the construction and lease-up period. For example, if you buy a building for a 5% cap rate, over a 2 year period you're foregoing 10% of the building's value. So basically a 5.5% YoC would in theory be a breakeven point (it's a tad crude since in practice you'd disperse capital in the form of draws).
Would you be able to post an image of this analysis? Or share the back-of-envelope model? Can PM you if so.
It's pretty basic but can share some screenshots. DM me.
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